Financial Statement Fraud: Motives, Methods, Cases and Detection

Khanh Nguyen

DISSERTATION.COM

Boca Raton

Financial Statement Fraud: Motives, Methods, Cases and Detection

Copyright 2008 Khanh Nguyen

All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any

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Dissertation.com Boca Raton, Florida

USA 2010

ISBN-10: 1-59942-319-7 ISBN-13: 978-1-59942-319-7

Abstract

Financial reporting frauds and earnings manipulation have attracted high profile

attention recently. There have been several cases by businesses of what appears to be

financial statement fraud, which have been undetected by the auditors.

In this Project, the main purpose is to focus on the nature of financial statement fraud,

and fraud schemes regarding to financial statements. The Project also discusses

common techniques used to detect financial statement frauds. Two cases of the

fraudulent financial statements of Enron and WorldCom are analysed.

II

Table of contents

Page

1. Introduction...

1.1 Background.

1.2 Research Issue and Purpose

1.3 Scope and Limitations.

2. Overview of Financial Statement Fraud...

2.1 Definitions of Fraud and Error....

2.1.1 Fraud

2.1.2 Error.

2.2 Types of fraud.

2.3 Definitions of Financial Statement Error and Fraud...

2.4 Types of financial statement fraud..

2.5 Who commit financial statement fraud?

2.6 Why do people commit financial statement fraud? ....

3. Financial statement fraud schemes...

3.1 Double-entry book-keeping

3.2 Accounting equation and financial statements....

3.3 Fraud schemes.

3.3.1 Selling more (overstatement of sales revenue)....

3.3.1.1 Sales (revenue) in improper periods.....

a) Bill and Hold Sales Transactions..

b) Channel stuffing (trade loading)...

c) Improper cut-offs of sales.

d) Shipping goods before a sale is finalized..

1 1 2 3 3 3 3 4 4 5 7 8 8 10 10 11 12 12 13 13 14 15 15

III

e) Recording sales (revenue) when uncertainties exist.

f) Side Agreements

g) Recording revenue when further services are still due.

3.3.1.2 Improper treatment of certain transactions as sales..

a) Fictitious sales...

b) Sales with conditions....

c) Indirect method of improper treatment of sales....

3.3.1.3 Improper Revenue Recognition Contract Accounting...

3.3.1.4 Improper revenue recognition Substance versus form...

a) One-time gains..

b) Less than arms length transactions..

3.3.1.5 Red flags of the overstatement of sales revenue...

3.3.2 Costing less (understatement of expenditure)..

3.3.2.1 Principle ...

3.3.2.2 Off-book expenditure (expense omissions)..

3.3.2.3 Aggressive capitalization of expenses..

3.3.2.4 Lax policy in charging expenses...

3.3.2.5 Red flags of understatement of expenditure..

3.3.3 Owning more (overstatement of assets)...

3.3.3.1 Principle ...

3.3.3.2 Tangible fixed assets.....

a) Overstating physical count

b) Inflating unit value of tangible fixed assets......

c) Delaying depreciation or amortization..

3.3.3.3 Inventories.

15 15 16 16 16 17 17 17 18 18 18 19 20 20 20 21 21 22 23 23 23 24 24 24 24

IV

a) Overstating physical count of inventories.

b) Inflating unit value of inventories.

c) Delaying write-off of inventories..

3.3.3.4 Accounts receivables.

a) Fictitious receivables

b) Failure to write down receivables

3.3.3.5 Red flags of overstatement of assets.

3.3.4 Owing less (understatement of liabilities) ...

3.3.4.1 Accounts payable .

3.3.4.2 Accruals and provisions

3.3.4.3 Unearned revenues........

3.3.4.4 Contingent liabilities.

3.3.4.5 Off-balance-sheet financing .

3.3.5 Manipulation of classification and improper disclosure..

3.3.5.1 Components of profits (gross profit, operating profit and net profit).......

3.3.5.2 Nature of occurrence.

3.3.5.3 Novelty in Terminology ...

3.3.5.4 Abuse of materiality concept .......

3.3.5.5 Misclassification of accounts

3.3.5.6 Inadequate disclosure of related party transactions..

3.3.6 Other shenanigans........

3.3.6.1 Shifting current income to later period.

3.3.6.2 Shifting future expenses to a current period ....

3.3.6.3 Tax evasion and theft

a) Tax evasion..

25 25 26 26 26 26 27 28 28 28 29 29 29 30 31 31 32 32 32 33 33 33 33 34 34

V

b) Theft.

4. Cases Analysis..

4.1 Enron...

4.1.1 Introduction..

4.1.2 Financial statement frauds at Enron.....

4.1.2.1 The abuse of Market-to-Market Accounting.....

4.1.2.2 The abuse of Special Purpose Entities (SPEs) .....

a) Using SPEs for hiding of debts (off-balance sheet financing)..

b) Using SPEs for hiding of poor-performing assets...

c) Quick execution of Related Party Transactions at desired prices.....

4.1.2.3 The prepay transactions.....

4.2 WorldCom...

4.2.1 Introduction..

4.2.2 Financial statement frauds at WorldCom.....

4.2.2.1 Improper use of merger reserves...

4.2.2.2 Improper capitalization of expenses .....

5. Detecting financial statement fraud..

5.1 Identify fraud exposures..

5.1.1 Management and the Board of Directors.

a) Backgrounds..

b) Motivations...

c) Ability to influence decisions...

5.1.2 Relationships with other entities..

a) Relationships with financial institutions ..

b) Relationships with related organizations and individuals (related parties)..

34 34 34 34 35 35 36 36 37 37 37 38 38 38 38 39 40 40 41 41 41 42 42 42 43

VI

c) Relationships between a company and its auditors...

d) Relationships with investors.

e) Relationships with regulators

5.1.3 Organization and Industry

a) Organization..

b) Industry and business environment ..

5.1.4 Financial results and operating characteristics.

a) Financial results

b) Operating characteristics...

5.2 Techniques and analyses to detect financial statement fraud..

5.2.1 Vertical analysis...

5.2.2 Horizontal analysis...

5.2.3 Ratio analysis...

5.3 Non financial data ..

6. Conclusion. References.

43 43 43 44 44 44 44 44 45 45 45 46 46 49 50 51

VII

1. Introduction

1.1 Background

Financial reporting frauds and earnings manipulation have attracted high profile attention

recently (Intal and Do 2002, 1). Over the past two decades, incidents of financial statement

fraud have increased substantially (Rezaee 2002, 18).

According to Wells (2005, 325-327), financial statement fraud is harmful in many ways. It:

Undermines the reliability, quality, transparency, and integrity of the financial

reporting process

Jeopardizes the integrity and objectivity of the auditing profession, especially

auditors and auditing firms, e.g. Andersen

Diminishes the confidence of the capital markets, as well as market participants,

in the reliability of financial information

Makes the capital markets less efficient

Adversely affects the nations economic growth and prosperity

Results in huge litigation costs

Destroy careers of individuals involved in financial statement fraud

Causes bankruptcy or substantial economic losses by the company engaged in

financial statement fraud

Encourages regulatory intervention

Causes devastation in the normal operations and performance of alleged

companies

Raises serious doubt the efficacy of financial statement audits

Erodes public confidence and trust in the accounting and auditing profession

1

For example, financial statement fraud committed by Enron Corporation is estimated to

have caused a loss of about $80 billion in market capitalization to investors, including

sophisticated financial institutions, and employees who held the companys stock in their

retirement accounts (Forbes 2007).

Furthermore, public statistics on the possible cost of financial statement fraud are only

educated estimates, primarily because it is impossible to determine actual total costs since

not all fraud is detected, not all detected fraud is reported, and not all reported fraud is

legally pursed (Rezaee 2002, 8). Therefore, financial statement frauds together with audit

failures have been increasingly a hot issue.

As a result, more people believe professional accountants have to learn how to detect

financial statement fraud more effectively. One of the best ways is to profit from the

mistakes of others. The consequences of individual cases (Enron, WorldCom ) above can

offer the profession an opportunity to learn and grow.

1.2 Research Issue and Purpose

In this Project, the main issue and purpose is to understand the real nature of financial

statement fraud (what it is; who, why and how to commit; a framework to detect and

prevent). In order to achieve this target, two cases (Enron and WorldCom) are chosen to

illustrate and analysis. Since two companies to study in this Project applied US Generally

Accepted Accounting Principles (GAAP), the analysis is conducted in accordance with the

US GAAP and appropriate regulations and laws.

1.3 Scope and Limitations

2

There are different types of financial statement fraud taking place in organizations, briefly,

according to (Kwok 2005) they can be categorized as follows:

Selling more

Costing Less

Owning more

Owing Less

Inappropriate Disclosure

Other Miscellaneous Techniques

Studying all of the above mentioned fraud categories since the topic is too broad and the

duration time of the Project writing does not allow to cover all of the techniques in depth.

The Project is researched theoretically because it is based on library research without

having the collection of data and other practical techniques (interviewing companies,

questionnaires and so on).

2. Overview of Financial Statement Fraud

2.1 Definitions of Fraud and Error

2.1.1 Fraud

According to (Singleton et al. 2006), fraud is a word that has many definitions:

Fraud as a crime. Fraud is a generic term, and embraces all the multifarious means which

human ingenuity can devise, which are resorted to by one individual, to get an advantage

over another by false representations. No definite and invariable rule can be laid down as a

general proposition in defining fraud, as it includes surprise, trickery, cunning and unfair

ways by which another is cheated. The only boundaries defining it are those which limit

human knavery (Singleton et al. 2006, 1-2)

3

Fraud as a tort. The U.S. Supreme Court in 1887 provided a definition of fraud in the civil

sense as (Bologna and Lindquist 1995, 9)

First: That the defendant has made a representation in regard to a material fact;

Second: That such representation is false;

Third: That such representation was not actually believed by the defendant, on reasonable

grounds, to be true;

Fourth: That it was made with intent that it should be acted on;

Fifth: That it was acted on by complainant to his damage; and

Sixth: That in so acting on it the complainant was ignorant of its falsity, and reasonably

believed it to be true.

2.1.2 Error

Error is a mistake which is unintentional (Albrecht and Albrecht 2003, 6). Therefore, fraud

is different from unintentional errors.

2.2 Types of fraud

According to (Albrecht and Albrecht 2003, 8), fraud can be classified into five types (Table

below). Fraud that does not fall into one of the five types and may have been committed for

reasons other than financial gain is simply labelled miscellaneous fraud.

4

Types of Fraud Victim Perpetrator Explanation

1. Employee Employers Employees Employees directly or embezzlement or indirectly steal from occupational fraud their employers.

2. Management fraud Stockholders, lenders, Top management Top management provides

and others who rely misrepresentation, on financial statements usually in financial information

3. Investment scams Investors Individuals Individuals trick investors into putting money into fraudulent investments.

4. Vendor fraud Organization that Organizations or Organization overcharge buy goods or services individuals that sell for goods or services or goods or services no shipment of goods, even though payment is made

5. Customer fraud Organizations that sell Customers Customers deceive goods or services sellers into giving customers something they should not have or charging them less than they should

As stated in the table above, financial statement fraud is the deliberate fraud committed by

management that injures investors and creditors with materially misleading financial

statements (Kerwin 1995, 36)

2.3 Definitions of Financial Statement Error and Fraud

Mis-statement or accounting irregularities in financial statements can arise from error or

fraud (Kwok 2005, 21). Therefore, it is helpful to distinguish between financial statement

error and financial statement fraud.

Financial statement error definition

Error refers to an unintentional mis-statement in financial statements, including the

omission of an amount or a disclosure, such as:

5

A mistake in gathering or processing data from which financial statements are

prepared;

An incorrect accounting estimate arising from oversight or misinterpretation of

facts; and

A mistake in the application of accounting principles relating to measurement,

recognition, classification, presentation, or disclosure (Kwok 2005, 21)

Financial statement fraud definitions

Financial statement fraud has been defined differently by academicians and practitioners.

Elliott and Willingham (1980, 4) view financial statement fraud as management fraud:

The deliberate fraud committed by management that injures investors and creditors

through materially misleading financial statements.

Besides investors and creditors, auditors are one of the victims of financial statement fraud.

They might suffer financial loss (e.g. loss of position, fines, etc.) and/or reputation loss

(Rezaee, 2002).

Gravitt (2006, 7) say that financial statement fraud may involve the following schemes:

Falsification, alteration, or manipulation of material financial record, supporting

documents, or business transactions

Material intentional omissions or misrepresentations of events, transactions,

accounts, or other significant information from which financial statements

prepared

Deliberate misapplication of accounting principles, policies, and procedures

used to measure, recognize, report, and disclose economic events and business

transactions

Intentional omissions of disclosures or presentation of inadequate disclosures

regarding accounting principles and policies and related financial amounts

6

Financial statement fraud is the most common fraud committed on behalf of an

organization through actions of the top management. Accordingly, the terms management

fraud and financial statement fraud are often used interchangeably.

2.4 Types of financial statement fraud

According to AICPA1 (2002), two types of intentional mis-statements are relevant to an

audit of financial statements and auditors consideration of fraud.

The first type is misstatements arising from fraudulent financial reporting, which are

defined as intentional misstatements or omissions of amounts or disclosures in financial

statements designed to deceive financial statement users

The second type is misstatements arising from misappropriation of assets. Misappropriation

of assets involves the theft of an organizations assets. Misappropriation of assets can be

accomplished in a variety of ways (including embezzling receipts, stealing physical or

intangible assets, or causing an organization to pay for goods and services not received).

Misappropriation of assets I often accompanied by false or misleading records or

documents in order to conceal the fact that the assets are missing, indirectly causing

accounting irregularities in financial statements (Kwok 2005, 22)

The primary focus of this Project is on the first type: misstatements arising from fraudulent

reporting that directly cause financial reports to be misleading and deceptive to investors

and creditors.

1 American Institute of Certified Public Accountants

7

2.5 Who commit financial statement fraud?

Financial statement fraud can be perpetrated by anyone at any level, who has the

opportunity. There are two main groups (Taylor 2004). In descending order of likelihood of

involvement, they are:

Senior management (CEO, CFO, etc.). CEO was involved in 72 percent of the

frauds while the CFO was involved in 43 percent. Either the CEO or the CFO

was involved in 83 percent of the cases (Wells 2005, 288)

Mid- and lower-level employees. These employees are responsible for

subsidiaries, divisions, or other units and they can commit financial statement

fraud to conceal their poor performance or to earn bonuses based on the higher

performance (Wells 2005, 288)

2.6 Why do people commit financial statement fraud?

Generally, it is noted that fraud like other crime, can best be explained by three factors: a

supply of motivated offenders, the availability of suitable targets and the absence of capable

guardians control systems or someone to mind the store (Sheetz and Silverstone 2007, 18)

Therefore, fraud typically includes three characteristics, which are known as the fraud

triangle (Turner, Mock and Srivastava 2003, i)

Opportunity Fraud triangle

Incentive/Pressure Attitude/Rationalization

Incentive/Pressure: Pressures or incentives on management to materially misstate the

financial statements.

8

There are many pressures. When financial statement fraud occurs, companies overstate

assets on the balance sheet and net income on the income statement. They usually feel

pressured to do so because of a poor cash position; receivable that are not collectible; a loss

of customers; obsolete inventory; a declining market; restrictive loan covenants that the

company is violating; unrealistic revenue and profit expectations; meet analysts

expectations; pending bankruptcy or delisting (Harfenist 2005).

Opportunity: Circumstances that provide an opportunity to carry out material misstatement

in the financial statements. The following opportunities may lead financial statement fraud

(Taylor 2004)

Absence or improper oversights by board of directors or audit committee

Weak or nonexistent internal controls

Financial estimates requiring significant judgments

Complex accounting rules (who is to blame?)

Complex organization structure

Highly complex transactions

Significant related party transactions

For example, Enron had complex structure: over 2000 subsidiaries (3500 affiliates); at 23

states and 62 countries. Enron also used complex accounting (special purpose entities).

Attitude/Rationalization: An attitude, character or set of ethical values that allows one or

more individuals to knowingly and intentionally commit a dishonest act, or a situation in

which individuals are able to rationalize committing a dishonest act (Harfenist 2005). For

instance, management can think of committing financial statement frauds like:

Competitors are doing it

9

The activity is not criminal

Ensuring companies goals are being met

It is just a timing issue

We are protecting shareholder value (by manipulating financial reports to

maintain or increase share prices).

3. Financial statement fraud schemes (how do people commit financial statement

fraud?)

3.1 Double-entry book-keeping

The fundamental idea of double-entry book-keeping is that all monetary transactions will

be recorded twice as debit and credit in the accounts based on the principle that every

monetary transaction involves the simultaneous receiving and giving of value (Hoggett,

Edwards and Medlin 2005).

Uncovering accounting irregularities often requires an understanding of the debits and

credits. Total debits must be equal total credits. If it is not, there must be errors (omission

and so on) in recording transactions or accounting irregularities because one side of the

accounting entries is missing (Hoggett, Edwards and Medlin 2005).

However, a balanced set of accounts does not guarantee the financial statements are free

from misstatements or accounting irregularities. For instance, a $10,000 cash shortfall, it is

plausible to suspect that the perpetrator may have attempted to conceal the theft (the credit

in the cash book) by labelling the stolen $10,000 as a legal expense (the debit in the legal

expense account).

10

A good understanding of the audit trail through various steps of the accounting cycle is

important in investigating accounting irregularities. They start with a source document such

as an invoice, a cheque, a receipt or a received report. These source documents become the

basis for accounting entries which effectively the chronological listings of the debits and

credits entries of transactions. Entries are made in various journals which are posted to the

appropriate general ledger account. The summarized account amounts become the basis for

financial statements for a particular year

3.2 Accounting equation and financial statements

According to Hoggett, Edwards and Medlin (2005), it is stated as follows:

The balance sheet is effectively an extension of the accounting equation by listing assets,

liabilities and capital. The balance sheet shows total assets, liabilities and owners equity at

a specific point in time (the last day of a financial year).

Assets = Liabilities + Capital (owners equity)

The profit and loss statement (income statement) show how much profit (or loss) an

organization has made during a financial year. On the income statement, two types of

accounts reported are revenues and expenses with the format as follows:

Profits = Revenues - Expenses

The capital in an organization usually can be viewed as from two sources: retained profits

and owners contributions (share capital). At the end of each financial year, revenues and

expenses on the income statement are closed and brought to a zero balance and the

difference, net profits (losses) are added to (or deducted from) retained profits on the

balance sheet

11

Assets = Liabilities + Share Capital + Retained Profits

(where Retained Profits = Profits Dividends)

Therefore, the income statement ties to the balance sheet through the retained profits

3.3 Fraud schemes

Revenue and Expenditure are in the profit and loss statement (income statement). Assets

and Liabilities are in the balance sheet. Moreover, Revenues (sales); Expenditures; Assets;

Liabilities are main categories of financial statements. Discussions of fraud schemes in this

Project are implemented following these categories.

3.3.1 Selling more (overstatement of sales revenue)

Sales (revenue) are usually the largest item in a Profit and Loss statement of most

organizations. Sales figures have a direct impact on the profit. They provide a good

indication of the activity level and capacity of the organization in question. Furthermore,

appearing on the first row in the Profit and Loss statement, the sales figures tends to attract

a significant level of attention from the readers of financial statements (Penman 2007).

Consequently, in recently years, investors in certain industries and start-up organization

usually focus on sales growth and acceleration as a reflection of an organizations potential

(Wild, Subramanyam and Halsey 2007)

Therefore, financial statement fraud involving overstatement of sales have the purpose of

portraying a selling more illusion and inflating the organizations profitability.

12

According to Wells (2005, 328), sales (revenue) generally are realized or realizable and

earned when all of the following criteria are met:

Sales are gross inflows of economic benefits from buyers to sellers

Sales are transfers of the significant risks and reward of goods or service from

sellers to buyers

Persuasive evidence of an arrangement exists

Delivery has occurred or services have been rendered

The sellers price to the buyer is fixed or determinable

Sales are final and unconditional, and sellers have no more influence and/or

control over the goods or service

Sales are quantifiable, the amount can be measured reliably

Collect ability is reasonably assured

Based on criteria above, accounting irregularities of sales are examined below

3.3.1.1 Sales (revenue) in improper periods

This scheme classifying a transaction as a sale before it is consummated or recording

revenues too soon (Zacharias 2001)

a) Bill and Hold Sales Transactions

Bill and hold is the term used to describe when a selling company holds merchandise to

accommodate a customer (Pesaru, 2002). In a bill and hold deal, the customer agrees to buy

goods by signing the contract, but the seller retains possession until the customer requests

shipment. An abuse of this practice occurs when a company (the seller) recognizes the early

revenue of bill and hold sales transactions (Young 2002, 109).

13

In the bill and hold deal, the transactions meet two conditions of (1) realized or realizable;

and (2) earned. However, commonly the revenue is recognized only when the goods and

services are delivered to the customers. Therefore, it is necessary to understand the

substance of the transactions to make sure that they are legitimate and arms-length

transactions (Rezaee, 2002).

b) Channel stuffing (trade loading)

Suppliers sometimes boost sales by inducing distributors to buy substantially more

inventory than they can promptly resell. Inducements to overbuy may range from deep

discounts on the inventory to threats of losing the distributorship if the inventory is not

purchased (Ogara 2004, 103).

Distributors and resellers sometimes delay placing orders until the end of a quarter in an

effort to negotiate a better price on purchases from suppliers that they know want to report

good sales performance. This practice may result in a normal pattern of increased sales

volume at the end of a reporting period. An unusual volume of sales to distributors or

resellers, particularly at or near the end of the reporting period, may indicate channel

stuffing (Intal and Do 2002).

The downside of channel stuffing is that by stealing from the next periods sales, it make it

harder to achieve goals in the next period, sometimes leading to increasingly disruptive

levels of channel stuffing and ultimately a restatement (Wells 2005, 333).

14

c) Improper cut-offs of sales

Perpetrators may also leave the books and accounts open for an excessively long time after

the financial year-end in order to record sales that are taking place after the year-end

(record sales of the subsequent reporting period in the current period) (Best et al. 2005,

509-510).

d) Shipping goods before a sale is finalized

In some situations, at the time of being close to the fiscal year-end, if the profits targets are

lagging, the management can commit financial statement fraud by shipping goods and

booking sales, even if the customers did not yet order the merchandise (Kerwin 1995).

e) Recording sales (revenue) when uncertainties exist

The seller still bears the risk of ownership (the risk of ownership has not been transferred)

and therefore a sale has not occurred.

There are cases where the seller makes some sales but concurrently agrees to repurchase the

same goods at a later date. In essence, the seller exercises a call option to repurchase, or the

buyer exercises a put option to resell to the seller of the same goods. When the seller has

retained the risks and rewards of ownership, even though legal title has been transferred,

the transaction is a financing arrangement and does not give rise to sales revenue (Sauer

2002)

f) Side Agreements

Management can use side agreements to alter the terms and conditions of recorded sales

transactions to aim at enticing customers to accept the delivery of goods and services.

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